As families earn more taxable income, government benefit entitlements are reduced (or “clawed back”) at various phase-out rates, which reduces their overall cost for governments and ensures that they remain targeted to the intended lower-income families. However, benefit reductions act like hidden tax rates: They reduce the effective gain from working to generate additional income. To determine the tax system’s full impact on a family’s financial gain from work, one must take into account the combined effect of both taxes paid and cash benefit reductions.This Commentary presents various estimates of effective tax rates on personal earnings for families with children. These effective rates play a key role in family work decisions by reducing the monetary reward of earned income. The “marginal” effective tax rate (METR) conveys the loss, through additional taxes and diminished benefits, associated with an extra dollar of earnings. For a working parent, it represents the financial penalty that must be paid from any small addition to their income. The “participation” tax rate (PTR) is the cumulative effect of all income taxes, other contributions, payroll deductions and loss of tax benefits on the entire prospective earnings from work.METRs have generally been higher for lower-income families than those of higher-income families. In some cases, the lower-earning parent in a dual-earner family with three children might lose more than 80 cents of an extra dollar of earnings, and an unemployed parent lose more than 60 percent of a prospective salary if they take on a job. Nationally, 15 percent of working lone parents or the lower-earning parents in dual-income families face a METR above 50 percent, and 14 percent of stay-at-home parents face a PTR above 50 percent. And these proportions have risen substantially since the mid-1980s and early 1990s when very few families faced a METR or PTR greater than 50 percent.To soften the bite of clawbacks on low-income families and encourage work Ottawa should:- Implement its own benefit shields, similar to that introduced by Quebec in 2016, that would focus on the Child Tax Benefit and the Canada Workers Benefit. Under the shield approach, a sudden jump in employment earnings would be excluded for the purpose of calculating income-tested benefit reductions in the first year of recipients’ higher income earning capacity, such that family benefits for the CCB and the CWB would remain the same for that year. The shields would likely stimulate parents to take on more paid work. The immediate cost of such benefit shields would likely be small in comparison to the long-term repeated annual government revenue yield from higher family earnings.- Allow income averaging to lessen the impact of fluctuating incomes on tax liability. Workers could average their income over many years, so that any single large earning year would not lead to a disproportionate loss of fiscal benefits and higher tax payments.- Replace the federal childcare expense tax deduction with a refundable credit for childcare costs with very generous rates for lower-earning families – designed along the lines of the Quebec and Ontario childcare expenses credits – diminishing up the income scale to higher-earning families, who would still reap some benefit.Clearly, geared-to-income fiscal benefit programs provide valuable financial assistance to families, but these benefits can result in low-income families facing very high METRs and PTRs. Federal and provincial policymakers should pay special attention to these effective tax rates when they consider changes to the tax and transfer system
